Authors: Gabe Parker, Galaxy; Compiled by: Wu Zhu, Jinse Finance
Abstract
Since 2021, Bitcoin-based Layer 2 (L2) projects have increased more than sevenfold, from 10 to 75. Over 36% of all venture capital in Bitcoin L2 was allocated in 2024, with a total of $447 million invested by crypto venture capital firms in Bitcoin L2 projects since 2018. Bitcoin L2 will leverage the funds raised to develop powerful applications and new use cases for BTC, aimed at attracting significant liquidity from local BTC holders and existing packaged BTC markets. The report estimates that over $47 billion of BTC could be connected to Bitcoin L2 by 2030. Our analysis of the total addressable market (TAM) for Bitcoin L2 considers the current market share of all BTC packaged versions used in DeFi, as well as native BTC stored in Bitcoin L2 and BTC locked in staking protocols. As of November 20, 2024, these segments accounted for 0.8% of all circulating BTC. By 2030, we estimate that 2.3% of the circulating supply of BTC will bridge to Bitcoin L2 to interact with the new Bitcoin DeFi ecosystem, alternative tokens, payment applications, etc.
Introduction
Since the inception of Bitcoin, discussions about its future have included the concept of layered scaling. Hal Finney described the idea of 'Bitcoin banks' in 2010, where 'Bitcoin-backed banks... [can issue] their own digital cash currency.' Tether launched on the Omni Network (one of the earliest Layer 2 networks) in 2014, an initiative described as 'Bitcoin 2.0'. The debate over whether Bitcoin should expand its base layer rather than develop high-performance L2 peaked during the 'block size debate,' which was largely resolved with the activation of SegWit on Bitcoin in August 2017 and the separate launch of Bitcoin Cash. SegWit enabled the payment-centric Lightning Network, which has been the most prominent L2 for years. Two notable sidechains were launched in 2018: Blockstream's Liquid (focused on asset issuance and payment privacy) and Rootstock (an EVM-compatible sidechain).
The rise of Ordinals has reignited tokenization activities back to the Bitcoin base layer in 2023 and helped rekindle interest in building applications on Bitcoin. This renewed interest, coupled with advancements in Rollup development within the Ethereum developer community, has sparked a new wave of Bitcoin Layer 2 projects, primarily utilizing Rollup technologies (optimistic and zero-knowledge). While the Lightning Network has achieved some success in enabling fast, cheap payments, developers have struggled to create yield-generating applications for BTC on the blockchain itself. A significant part of the difficulty arises from Bitcoin's inability to support general smart contract applications. The Bitcoin base layer is not Turing complete, thus unable to execute the smart contract logic required by most DeFi applications. However, future upgrades may enable enhancements to multi-party computation, resulting in more robust bridging and Layer 2 architecture. Although upgrades enabling Turing completeness for Bitcoin are not yet realized and unlikely to be achieved, some Bitcoin holders are already operating their BTC in DeFi or earning yields by bridging assets to other Turing-complete environments instead of high-performance, trust-minimized Layer 2s like Ethereum's complete blockchain. The packaged Bitcoin (WBTC) on Ethereum represents the largest share of all wrapped versions of BTC (62%). The wrapped versions of BTC used in Ethereum's DeFi represent a large group of BTC holders seeking more efficient BTC use cases.
The more than $9 billion in packaged BTC (WBTC, tBTC, cbBTC) on Ethereum may indicate demand from users for utilizing BTC in DeFi applications. Holders of WBTC, tBTC, and other bridged BTC are more likely to transfer and use BTC on new Bitcoin L2s since they are familiar with operating wrapped BTC assets on other chains. Bitcoin L2 may prioritize developing attractive BTC-denominated yield-generating applications to entice existing wrapped BTC users on Ethereum to move their funds to the new Bitcoin L2. Wrapped BTC holders may also use Bitcoin L2 because they have already shown a preference for utility over decentralization. All launched Bitcoin L2s will be more centralized systems than Bitcoin L1, although some will have decentralized features comparable to existing Ethereum L2s.
The ability to use BTC in DeFi applications without exiting the Bitcoin ecosystem is an important selling point of Bitcoin L2. It may reduce friction in the user experience of bridging BTC and provide a more secure alternative for using BTC in DeFi beyond existing solutions. One major benefit of Bitcoin DeFi on Bitcoin L2 is that BTC serves as both the native gas asset and the focus of DeFi development. Historically, native assets have shown greater utility on their local blockchain compared to external networks. For example, the significant borrowing demand for ETH in Ethereum DeFi applications stems from its indispensable role as Ethereum's native gas token and its widespread adoption as the primary unit of account for NFTs and fungible tokens. The evolution of the DeFi ecosystems on platforms like Ethereum and Solana illustrates an important principle: strong DeFi economies are built around the native assets of the blockchain.
This report defines the key features of Bitcoin L2 and provides a high-level overview of different types of Bitcoin scalability solutions. The report also provides a detailed account of $447 million in cryptocurrency venture capital invested in Bitcoin L2 since 2018 and offers an analysis of the TAM for emerging Bitcoin L2. Finally, the report shares important insights into the future prospects of Bitcoin modularity.
What is Bitcoin Layer 2?
Bitcoin L2 provides higher transaction throughput than Bitcoin L1 by implementing larger and faster blocks. Bitcoin L2 acts as its own execution environment and can thus circumvent the technical limitations present on Bitcoin L1, such as the lack of Turing completeness. By acting as an independent execution environment, Bitcoin L2 can use its own consensus mechanism, security framework, and virtual machine. For example, most Bitcoin L2s in production are EVM-equivalent or compatible, allowing them to integrate applications from other EVM blockchains. (For more information on EVM equivalence and compatibility, refer to Christine Kim's report on Ethereum ZK-Rollups.)
Another key determinant for Bitcoin L2 is their bridging mechanism, which refers to how users transfer BTC from the base layer to L2. Bitcoin L2 employs a wide range of bridging frameworks, including multisig and multi-party computation (MPC) wallet schemes, as well as third-party bridges. Some Bitcoin L2s use multisig/MPC wallet schemes with BitVM, which is an off-chain Turing-complete virtual machine compatible with Bitcoin. At a higher level, the BitVM bridge involves a 1-of-n trust assumption where only one honest bridge operator needs to be online for users to exit the bridge. MPC and multisig bridges typically require over 50% of signers to be honest for users to exit the bridge.
The main difference between Bitcoin L2 bridges and Ethereum L2 bridges is that the latter involves smart contract accounts while the former uses Bitcoin public key addresses. However, in both cases, the smart contract accounts on Ethereum and the Bitcoin public key addresses are typically controlled by a set of private keys. Another key distinction is that Bitcoin L2 bridges for sidechains and Rollups do not allow unilateral exits, meaning users cannot exit L2 without trusting intermediaries. Ethereum Rollups may include a feature known as forced withdrawal, which allows anyone to directly submit their transaction to L1 to extract funds from the Rollup in case the sequencer is offline or unable to include user transactions. State channels are the only Bitcoin L2 with trustless unilateral exits. The construction of Lightning Network bridges is designed to allow users to seamlessly withdraw funds back to L1 as long as they maintain the latest balance state.
Bitcoin Rollup and Sidechain
There are two categories of Bitcoin L2 solutions that can support general application development: Rollups and Sidechains. State channels are another L2 solution developed on Bitcoin, most notably the Lightning Network, but this technology is primarily used for faster and cheaper peer-to-peer transactions on Bitcoin and currently does not support Turing-complete smart contracts.
Sidechains: Sidechains are essentially independent blockchains that run in parallel to the base layer through embedded connections with their own node operators and security mechanisms. Sidechains scale the base layer by creating independent compatible blockchains with larger blocks and faster block times. As a result, more transactions can be processed in a shorter time. Since sidechains use their own consensus model, they do not rely on a data availability layer but serve as closed and independent execution environments. Some critics argue that sidechains are not technically 'Layer 2' solutions but rather standalone Layer 1 expansions. However, sidechains can be designed in various ways, making it important to distinguish between those that are consistent with the base layer and those that are not. Sidechains can publish hashes of block headers or other data to L1 as a way to checkpoint their own state to L1.
Rollup: Rollup is a blockchain that offloads transactions from the base layer and executes them on a secondary layer. Therefore, Rollup provides users with transactions that are 10 to 100 times cheaper and faster. By using transaction data compression algorithms that batch multiple transactions together, Rollup can achieve higher transaction throughput than sidechains.
Rollups also utilize a parent blockchain for data availability. The parent blockchain stores the state root, transaction data, or state differences of the Rollup. The data stored on the parent blockchain allows any full node to reconstruct the latest state of the Rollup. Rollups can be designed to support a single application or provide general functionality and host multiple applications.
Rollups update the state root in two ways. Validity Rollups (also known as zk-Rollups) create succinct cryptographic proofs that L1 immediately verifies upon receipt of updates, proving that the updates are consistent with the correct execution of those transactions. Optimistic Rollups push the optimistic correct state root updates to L1 and provide validators with a defined time window to challenge the state root updates.
The classification of the market map above follows these main features:
Bitcoin Rollup: Publish proofs and state difference data or transaction data to the Bitcoin blockchain in the execution layer.
Rollup not on Bitcoin: An execution layer that publishes proofs and state difference data or transaction data on Ethereum or alternative DA layers.
Sidechain: An independent execution layer compatible with the Bitcoin base layer that does not require DA from the parent chain.
Infrastructure: Data availability protocols and any wrapped BTC providers.
State Channel: An off-chain execution environment with no global state, only submitting the initial and final account balances.
ECASH: A custodial state channel solution based on David Chaumian's Ecash proposal.
Virtual UTXO and CSV: New iterations of state channels and execution layer validated by clients.
Valid Chain: The execution layer is compatible with BTC and utilizes off-chain or alternative DA.
The market map does not include every project in each category and is for reference concerning the construction of different types of projects in the Bitcoin L2 ecosystem. As of November 20, 2024, the Bitcoin L2 market consists of 40 Rollups and 25 sidechains. This report does not cover state channels, CSV, Drivechain, or ECash protocols, which collectively represent 10 projects.
Bitcoin L2 Venture Capital
As of September 2024, Bitcoin L2 has raised $174 million from cryptocurrency venture capital firms. Of this, sidechains received the largest allocation of $105 million, followed by Rollups at $63 million. Notably, in 2024 alone, 39% of all historic venture capital for Bitcoin L2 occurred. A significant shift occurred in Q2 2024, with Bitcoin L2 capturing 44% of all cryptocurrency venture capital allocated to L2 solutions, a 159% quarter-over-quarter increase, which is astonishing. In 2024, cryptocurrency venture capital investments in Bitcoin L2 surged, highlighting that traditional cryptocurrency venture capital (excluding funds focused on Bitcoin) had nearly no exposure to the Bitcoin ecosystem before the fundraising and development early in 2024. By November 2024, Bitcoin L2 had undergone two rounds of Series A funding, involving 30 disclosed transactions.
Since 2018, Bitcoin Layer 2 has attracted significant investment, with sidechains in the lead. Of the total investment of $447 million in Bitcoin L2, sidechains received the largest share at 64%. State Channels followed at 22%, and Rollups accounted for 14%. Notably, protocols based on ECASH, such as Cashu and Fedimint, were not included in the table above and received a total of $27.2 million in venture capital. Electronic cash projects do not meet our definition of Bitcoin L2 but are worth noting as potential infrastructure in the Bitcoin L2 space.
Potential Market for Bitcoin L2
We believe the directly addressable market for Bitcoin L2 is the total supply of BTC in wrapped versions in DeFi contracts, native BTC bridged to L2, and BTC in staking protocols. The demographics of 'active' BTC supply are the focus of our TAM analysis. We believe this group of holders is most likely to connect their BTC with the new L2 in search of yield opportunities.
As of November 20, approximately 0.8% of BTC circulation (164,992 BTC) is actively being utilized. For the wrapped BTC market, $10 billion is locked in DeFi smart contracts, and $247 million is locked in Bitcoin L2. For native Bitcoin, $3.4 billion is locked in staking protocols (Babylon, Bouncebit), and $1.5 billion is locked in Bitcoin L2.
If we assume that the share of circulating BTC supply used in DeFi, L2, and Staking increases by 0.25% annually over six years, we estimate that by the end of 2030, the 'active BTC supply' could grow to 471,806 BTC (approximately tripling).
In contrast, 2.3% of Ethereum's circulating supply (ETH, WETH, stETH, wstETH) is locked in DeFi smart contracts (excluding staking protocols). At current prices as of November 20, 2024, this model predicts that Bitcoin L2's TAM will reach $44 billion by 2030.
If Bitcoin reaches $100,000 by 2030, the TAM for Bitcoin L2 could reach $47 billion, assuming that 2.3% of Bitcoin's total supply is locked in Bitcoin L2 by 2030.
Please note that this analysis can roughly estimate how much BTC supply could flow into Bitcoin L2 for yield; it does not account for the potential growth of the Bitcoin L2 ecosystem, which includes other crypto assets that will be issued on top of these L2s, such as runes, ordinals, stablecoins, etc. Our TAM estimate relies on two key assumptions. First, we assume that the percentage of BTC supply locked in Bitcoin L2 may grow by 0.25% annually from now until 2030; second, we assume that the price of BTC could reach $100,000 by 2030. Our view is that these are conservative estimates of future demand and Bitcoin price for Bitcoin L2 users over the next six years.
It is also worth noting that our projections depend on the progress of Bitcoin's DeFi and staking ecosystem on L2 while establishing legitimacy over the next six years. Crucially, if the DeFi yields on new Bitcoin L2 are not attractive enough, the wrapped BTC supply on Ethereum may remain within the Ethereum ecosystem. The following sections will focus on the minimum yield levels required for DeFi applications on Bitcoin L2 to compete with DeFi applications on Ethereum that accept wrapped versions of BTC.
Gaining Market Share from BTC DeFi on Ethereum
Despite new wrapped versions of BTC being used in DeFi, this section focuses solely on WBTC, as this token accounts for 62% of the wrapped BTC market.
To capture significant market share from WBTC, lending protocols on Bitcoin L2 must 1) offer higher supply yields by increasing BTC utilization (users borrowing BTC), and 2) provide ample stablecoin liquidity for lending. Approximately 72% of all WBTC locked in DeFi contracts is deposited into lending protocols. The large share of WBTC in lending protocols indicates that this group of BTC holders is only interested in lending applications. Additionally, on the two major lending protocols on Ethereum, Aave and MakerDAO, for every $100 deposited in WBTC, approximately $50 in stablecoins is borrowed.
By observing the average utilization rates of these deposit pools, it is clear to see the significant stablecoin borrowing against WBTC on AAVE and Maker. On AAVE, the average utilization rate for WBTC is 7.7%, meaning that 92.3% of the deposited WBTC is used as collateral for stablecoin loans. As of November 2024, the average annual interest rate for WBTC deposits on AAVE is only 0.04%. For reference, the utilization rate for WETH on AAVE is 89%, with WETH deposits generating an annualized yield of 2.3%.
The utilization rate of ETH/WETH is far higher than that of WBTC. Use cases for WETH include DeFi, perpetual trading, staking, and NFTs. Lending applications on Bitcoin L2 aim to enhance the utility of BTC by building a dedicated ecosystem for the asset, thus providing higher yields. Some examples include ordinals and alternative token protocols built on Bitcoin L2.
The following table highlights the yields from depositing wrapped BTC into loan protocols and DEX pools on Ethereum.
While depositing WBTC into DEX pools can offer higher yields compared to loan pools, the risks of impermanent loss and yield volatility make DEX pools an unreliable source of income. Therefore, 72% of WBTC's DeFi contracts are allocated to lending protocols. Borrowing BTC on Bitcoin L2 exceeds the borrowing activity of WBTC on Ethereum, as lending protocols on Bitcoin L2 will provide higher yields due to improved utilization of the underlying asset.
Summary
DeFi applications on Bitcoin L2 need to offer higher yields than Bitcoin DeFi on Ethereum to capture market share from the wrapped BTC market. Bitcoin L2 can only succeed by capturing market share from DeFi applications that accept BTC tokenized versions such as WBTC, tBTC, and cbBTC. A vibrant DeFi ecosystem on Bitcoin L2 is the most crucial development for the long-term adoption of L2. This is evident when looking at the top applications on Ethereum L2 (Arbitrum, Optimism, and Base) by TVL, which include lending, DEX, and derivatives platforms.
The trust assumptions of the new Bitcoin L2 bridge designs are no weaker than those of the bridge designs for WBTC, cBTC, and tBTC. WBTC holders need to trust BitGo's consortium, a centralized entity, while BTC holders on Bitcoin L2 need to trust a relatively more decentralized group of bridging operators. Although there is no unilateral exit for any Bitcoin Rollup or sidechain, once this feature is developed, the bridging on new Bitcoin L2 will be less trustworthy than WBTC, cBTC, and tBTC.
In 2024, Bitcoin L2 received $174 million in venture capital, providing a platform for these projects to execute market strategies. Bitcoin L2s that raised significant funds will establish ecosystem funds and use this capital to install existing EVM applications. Ongoing investment in the Bitcoin L2 ecosystem will play a crucial role in the industry's growth over the next six years. Once Bitcoin L2 goes live on the mainnet, cryptocurrency venture capital firms may shift to investing in early native applications.
The emergence of Ordinals and BRC-20 in 2023 has signaled to cryptocurrency venture capital firms that Bitcoin may offer another investment opportunity beyond digital gold. As Bitcoin L2 matures and its user base expands, cryptocurrency venture capital firms will continue to deploy funds into the Bitcoin ecosystem.
Out of the 75 Bitcoin L2s today, only 3-5 participants may ultimately capture the largest market share. There will not be enough users, liquidity, and attention to allocate across 75 Bitcoin L2s. We emphasized this point in our previous reports regarding Bitcoin Rollups utilizing DA. The L2s with the most liquidity and yield-generating applications may be the only projects able to survive over the next six years. Therefore, partnerships for business development in infrastructure, liquidity provisioning, and market-making will be critical to determining which Bitcoin L2s will lead over others.
